Sections 125 and 132(f) of the Internal Revenue Code of 1986 (26 USC §§ 125, 132(f), hereinafter IRC) provides that employees may purchase certain employee benefits using pre-tax dollars. Under an individual salary reduction arrangement with the employer, an employee may request the employer to set aside a part of his ordinarily taxable wages for purchasing benefits, without having such amounts being taxed for income and employment tax purposes. Among others, the benefits may include health care benefits and dependent care benefits, as well as expenditures related to commuting to work, such as fare media for public transit and qualified parking or van pool fares (e.g., hereafter collectively Commuter Benefits). Business expenses subject to similar substantiation and adjudication rules are governed by IRC Sections 61, 162, and 274.
Typically bookkeeping accounts (called Flexible Spending Accounts, hereafter “FSA”), are established between the employer and the employee to account for the employee's salary reduction and the payments for health care and dependent care. Generally, under such an arrangement, an employee requests the employer to set aside certain amounts of his wages for a plan year to pay for qualified health or dependent care benefits. The employer then deducts from each paycheck an amount equal to the annual election divided by the number of payroll periods in the plan year. The employee can then request payment for benefits from the flexible spending account (FSA). The payments from these accounts for qualified benefits are not taxable to the employee.
Generally, each type of benefit (e.g., health care and dependent care, etc.) must have its own separate FSA. This is because, among other things, the different way benefits are available from each type of account.
Traditionally, benefits from FSA are paid through a reimbursement process. Under a reimbursement process, an employee submits a claim to a claim administrator for adjudication. The claim administrator can be the employer or a third party administrator (TPA). The regulatory requirement for claim reimbursement is that the employee must submit:                a statement from the provider indicating that medical services or products were sold to the employee (or to his spouse or dependents), and the amount of the expenses, and        a statement by the employee that the claim has not been reimbursed and is not reimbursable by other insurance.        
A conventional process is illustrated in FIG. 1. In a conventional reimbursement process, the employee directs his employer to set aside part of each paycheck for future benefits at step 101 (that is, the Annual Election). At step 103, the employer establishes an FSA for the employee and credits the account with the amount the employee elected to set aside at step 101. The employee then buys an eligible item, such as prescription drugs, at step 105 using his own money. At step 107, the employee completes and submits a paper claim form accompanied by paper receipts to a claims administrator. The receipt must satisfy the third party statement requirement. That is, it must state that eligible services or products were provided and the amount paid. The claim form may also contain the employee statement that the claim has not been reimbursed or is not reimbursable by other insurance or plans. At step 109, the administrator reviews the documents to determine whether the item is eligible for reimbursement under the law. At step 111, the administrator further reviews whether the amounts were stated on the receipt. At step 113 the administrator further reviews whether the employee's FSA has sufficient balance to pay such expenses. At step 115, if the claim is determined reimbursable under steps 109 through 113, the administrator issues a check for the amount of claim to the employee. At step 117, the administrator debits the employee's FSA for the amount of benefits paid. If the claim failed to satisfy any one of the steps 109, 111 or 113, the claim is denied and the administrator issues a letter of denial to the employee at step 119.
One problem with this arrangement is that the employee must prove that the expenses were legally eligible for reimbursement. It is too complicated for most employees to determine whether an expense is eligible before submission. Employee either fails to submit eligible claims or submits all claims regardless of eligibility. The former results in underutilized benefits, while the latter results in high costs to the employer because it must adjudicate both eligible and ineligible claims.
A second related problem is that the adjudication process is not transparent to the employee. There is no feedback to the employee. For example, the employee is not normally notified that the claim form was received, the claim form was completed properly, or that the claim is being adjudicated. Occasionally, the claim may be rejected with reasons that are not entirely clear to the employee, at which point the employee must initiate a claim review process with the administrator. This results in frustration to the employee and added costs to the employer.
A third problem with the reimbursement arrangement is the cash flow burden on the employee. The employee essentially must pay twice before he can request a reimbursement: the first time by reducing his salary and the second time by paying for the services. Since the typical reimbursement process can take from 30 to 90 days, the cash flow burden is too much for most employees, so they may rather forgo the tax savings by not participating in the plan.
In addition, a conventional method often involves human processes which may lead to undesirable errors. For example, a human may misread or fail to read handwritten notations on a receipt and erroneously deny or approve a claim.
Furthermore, when an employee of a corporation travels during a business related trip, often some but not all expenses are qualified for business expenses. The employee needs to itemize in paper work in order to claim the expenses as business expenses for the tax purposes. Such paper works discussed above pose significant burdens on the business people. Thus, better solutions are desirable.